By Dmitrijs Kukels, Chief Brokerage Officer at Dukascopy Bank
As the Chief Brokerage Officer of Dukascopy Bank, I have been involved so many times in discussions regarding ECN. To stop this unending process, I decided to write this article and share the knowledge and expertise I have on this topic. I hope it will help to clarify it.
Dukascopy was among the first forex brokers to create its own ECN model and provide it to retail traders. Nowadays, many forex brokers claim to be ECNs. But what does ECN actually mean? And what are the benefits of an ECN for the trader?
ECN is an abbreviation for Electronic Communication
Network. According to Wikipedia, "an ECN is generally an electronic system that
widely disseminates orders entered by market makers to third parties and
permits the orders to be executed against in whole or in part". Such a definition
allows many interpretations and variations, and does not clearly describe the benefits
To answer this question, let's go through the main principles, which I believe to correspond to the true ECN.
Equal trading rights and price feed transparency
All the traders receive the same price feed and trade at the same prices. The historical price
feed must be publicly available in tick format, which means the values of each and every price at a given moment.
This approach guarantees that price manipulation
is not possible.
Trading conditions are the same for all the traders, the only difference being trading commissions (that are charged in addition to the spread). In case of any issue, each trader can compare the prices of order executions with historically quoted prices as well as with order execution prices of other traders, since all the traders are getting the same feed. Such a transparent environment makes it possible to verify order execution prices and protect the clients' interests.
Liquidity and liquidity providers
The price feed provided by an ECN is based on the prices received from liquidity providers - banks, brokers and private ECN traders. Liquidity providers are in competition among themselves for getting more trading orders. Liquidity providers are motivated to quote better in order to get higher trading volume.
All provided liquidity is accumulated in the market depth, which shows all offered prices and proposed volume for each price level. Trading orders are first sent at the best prices, and if proposed liquidity is not sufficient to fulfill the total amount of the order(s), then the next bid and offers (market depth levels) are used.
The ECN model allows to quote BID and ASK prices from different providers. As a result, ECN trading spreads are tighter than what any liquidity provider can propose individually. Due to the aggregation of prices from different sources, fixed spreads are not possible within an ECN environment. A true ECN only quotes variable spreads.
Due to internet delay, it can sometimes happen that quotations of liquidity providers create negative spread. However, our experience clearly shows that in most cases such quotations are not executable, and are related to old prices. To avoid order rejections, a special filtration method has to be implemented. At Dukascopy, we drop (i.e. consider not executable) all quotations from a negative spread zone using the following principle: we remove the oldest quotation, then check if the spread is negative, if yes we remove the next oldest quotation etc., until the current spread is positive. This method gives the lowest reject ratio.
Each private trader who is trading on an ECN is able to set their own BIDs and OFFERs in the ECN price feed, and can become a liquidity provider for other traders. In practice, this means that private investors (any trader) can win the spread by offering their own prices to other ECN participants and sell at ASK price or buy at BID price if other traders hit their offers. ECN brokers can add their own additional liquidity as well. Adding own liquidity helps other clients to reduce the amount of rejects and possible slippage.
Combining bids and asks from different sources allows to accumulate a large liquidity and create an independent price feed. A larger liquidity allows traders to execute large orders at better prices, without impacting the market (as trades will be redistributed among many banks and brokers; none of them will receive a large order). It also allows them to get better execution prices during high volatility moments (like news announcements or important events). For example on 15.01.2015, when EURCHF floor was cancelled by the Swiss National Bank, Dukascopy clients were able to close their positions much better than with many other brokers, thanks to the large liquidity.Creating prices based on other providers' prices allows to determine an independent market price. Receiving prices from multiple providers and collecting the best ones, protects against a single provider's spikes, spread widening or stop hunting.
These principles are mandatory requirements of any ECN. Any stock exchange corresponds to the above-mentioned criteria, however not all the brokers claiming to be an ECN have all the necessary attributes. In order to avoid any misleading, we invite traders to check themselves whether their broker is an ECN or not.
Even if a broker matches all the above-mentioned ECN criteria, the license and regulation under which a broker is operating play a very important role. If the broker's activity is not properly audited and reviewed by independent auditors/regulators, then this broker can't be considered reliable, even while being considered an ECN. For example, Dukascopy Bank regularly passes independent audits performed by external auditing firms on various topics. Additionally, a strong regulation introduces many standards and requirements, which aim to protect the clients' interests and increase the stability of the firm. A breach of the regulators' requirements may lead to fines or to the loss of the license. In case of weak regulation, the broker is free to do any tricks, take too much risk and be dishonest.
Another important legal aspect is the counterparty of the deal. When dealing with a FX/CFD ECN broker, depending on the type of license the broker may be the counterparty to all trades or just an intermediary. For example, in the case of Dukascopy Bank, the regulation allows it to be the counterparty for clients' trades. If a client sends an order that is later hedged with one of the external liquidity providers, Dukascopy Bank will remain the counterparty of the trade for the client. At the same time, the license of Dukascopy Europe, the European subsidiary of Dukascopy Bank, allows to be the only intermediary between the client and the place of execution (which is Dukascopy Bank). In both cases, clients are trading in an ECN environment.
Provided information allows any trader to verify whether the broker they are trading with is an ECN or not.
In the past, the ECN model was available mainly for institutions or high net worth clients. Nowadays, the SWFX Swiss Forex Marketplace ECN engine created by Dukascopy is also available for retail clients thanks to Dukascopy Europe. Unlike usual ECN offers, which require significant lot sizes and relatively high initial deposits, ECN accounts in Dukascopy Europe are available for lot sizes from 1K and an initial deposit of 100 USD. I invite you to get your own experience of trading with a real ECN at www.dukascopy.eu
Chief Brokerage Officer,